A mortgage is a loan used to finance the purchase of your home. It is one of the largest and most important investments that you’ll ever make. This is how it works. Your home serves as the collateral for the loan that you agree to pay over 15 to 30 years with interest. Monthly payments typically include the principle (the sum financed by your mortgage bank), interest (the interest charged to you for borrowing money) and taxes (usually community taxes based on a percentage of the value of your home). When you put down less than 20% on the purchase of your home, most mortgage banks charge private mortgage insurance (MI) premiums. This coverage is designed to protect the bank against you not paying your mortgage.

There are two basic formulas commonly used to determine how much of a mortgage you can reasonably afford. These formulas are called qualifying ratios because they estimate the amount of money you should spend on mortgage payments relative to your income and other expenses.

The following ratios may vary and each application is handled on an individual basis, and so the guidelines are, in fact, just guidelines. There are many affordability programs, both government and conventional, which have lenient requirements for low- and moderate-income families.

As a general rule of thumb, to qualify for conventional loans, housing expenses should not exceed 26% to 28% of your gross monthly income. The ratio for FHA is 29% of gross monthly income. Monthly housing costs include the mortgage principal, interest, taxes and insurance. If your annual income is $38,000, your gross monthly income is $3,000, times 28% = $840. So you would probably qualify for a conventional home loan that requires monthly payments of $840.

Any expenses that extend 11 months or more into the future are called long-term debt, such as a car loan. Total monthly costs, including long-term debt, should exceed 33% to 36% of your gross monthly income for conventional loans. Using the same example, $3,000 x 36% = $1,048. Therefore, your total monthly housing expenses, along with any monthly long-term debt, cannot exceed $1,048. For FHA, the ratio is 41%.

One method of determining just how much to spend for housing is to compare your monthly income with monthly long-term obligations and expenses. Be sure to only include income you can definitely count on.

When budgeting to buy a home, it is important to allow enough money for additional expenses, such as maintenance and insurance costs. If you are purchasing an existing home, gather information on cost averages and maintenance costs from previous owners to help you better prepare for homeownership.

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Homeowner's insurance or property insurance is another cost you will have to consider. The lending institution holding the mortgage will require insurance in an amount sufficient to cover the loan. However, to protect the full value of your investment, you might want to consider purchasing insurance that provides the full replacement cost if the home is destroyed. Some insurance only provides a fixed dollar amount that may be insufficient to rebuild a badly damaged house.